Chapter 34

1. Chapter 34 Trade Policy

2. In this chapter you will learn to 1. Describe the various situations in which a country may rationally choose to protect some industries. 2. Describe the most common fallacious arguments in favor of protection. 3. Describe the effects of a tariff or quota on imported goods. 4. Explain why trade-remedy laws are sometimes just thinly disguised protection. 5. Explain the distinction between trade creation and trade diversion. 6. Describe the main features of the North American Free Trade Agreement.

3. Free Trade or Protection? Protectionism: - any policies designed to protect domestic industries from foreign competition Important examples: - tariffs - nontariff barriers - import quotas and VERs - cumbersome customs regulations

4. The Case for Free Trade Free trade encourages countries to specialize along the lines of comparative advantage:  allows an increase in average material living standards The gains from specialization and trade make the country as a whole better off. But free trade does not necessarily make every individual better off.

5. The Case for Protection Two important valid arguments for protection: 1. Objectives other than maximizing national income a) Diversification - advantages from a diversified pattern of production b) Social - the protection of specific groups In both cases, the cost is reduced average income.

6. The Case for Protection 2. Maximize national income, possibly at the expense of other countries’ incomes: • a) Improve the terms of trade • - only possible for large countries • b) Protect “infant” industries • - do scale economies exist? • - must make sure they eventually “grow up” • c) Earn pure profits in foreign markets • - “strategic” trade policy

7. Fallacious Arguments for Protection Many arguments against free trade are based on popular misconceptions about markets and economies: • a) Protectionist policies help “keep the money at home” • b) Protection from low-wage foreign labor • c) Exports are “good” whereas imports are “bad” • d) Protectionist policies create more domestic jobs

8. Methods of Protection Tariffs Consider the market for some imported good with a world price of pw . Price D S world price • Under free trade, domestic production is Q1whereas domestic consumption is Q2. pw • • Imports Q1 Q2 Quantity

9. Figure 34.1 The Deadweight Loss of a Tariff Domestic producer surplus rises by area 1. Domestic consumer surplus falls by areas 1 + 2 + 3 + 4. Imports fall, but the government receives tariff revenue equal to area 3. The overall loss to the domestic economy = 2 + 4

10. Quotas and Voluntary Export Restraints (VERs) The same result can be accomplished by a quantity restriction: - import quota - voluntary export restriction (VER) Same effect on the domestic consumers and producers: - but foreign producers now receive higher price - area 3 is extra revenues for foreign producers rather than tariff revenues for government

11. Figure 34.2 The Deadweight Loss of an Import Quota Deadweight loss = Areas 2 + 3 + 4

12. Tariffs versus Quotas? In general, a quota and a volume-equivalent tariff have different welfare implications for the two countries. - exporting country prefers a quota - importing country prefers a tariff The recently resolved Canada-U.S. trade dispute over softwood lumber is a good example of the use of both tariffs and import quotas.

13. Trade-Remedy Laws and Nontariff Barriers Some nontariff barriers were originally created to remedy problems that arise from international trade. Dumping: - when a product is sold in export markets for a lower price than in the domestic market for reasons unrelated to costs Countervailing duties: - a tariff used to offset the effects of subsidies paid by foreign governments

14. Current Trade Policy The GATT and the WTO Under the GATT, countries agreed to reduce trade barriers through multilateral negotiations and not to raise them unilaterally. With the end of the Uruguay Round in 1994, the GATT was succeeded by WTO. The current round is the Doha Round (2000) - the very contentious issue is agriculture

15. Current Trade Policy • In recent years, there has been an emerging debate about the WTO: • - should environmental and labor issues be included within the agreements? • - are the negotiations undemocratic? • - the Doha Round includes very little on environmental issues and labor standards

16. Regional Trade Agreements • Attempts to liberalize trade over a much smaller group of countries include: • free-trade agreements (e.g., NAFTA) • customs unions (e.g., Mercosur) • common markets (e.g., EU)

17. Regional Trade Agreements Trade agreements usually reallocate resources through two effects: • Trade creation • When producers in one member country find that they can export to another member country as a result of the elimination of the tariffs. • For example: • Under NAFTA, some U.S. firms find that they could undersell their Mexican competitors in some product lines, and some Mexican firms find that they could undersell their U.S. competitors in other product lines.

18. Regional Trade Agreements 2. Trade diversion When exporters in one member country replace foreign exporters as suppliers to another member country. For example: Under NAFTA, U.S. firms find that they can undersell competitors from the rest of the world in the Mexican market, not because they are the cheapest source of supply, but because their tariff-free prices under NAFTA.

19. Trade Creation versus Trade Diversion Trade creation represents efficient specialization according to comparative advantage. From the global perspective, trade diversion represents an inefficient reallocation of resources.

20. Trade Creation versus Trade Diversion APPLYING ECONOMIC CONCEPTS 34.1 Should the WTO Be Abolished?

21. The North American Free Trade Agreement NAFTA is guided by the fundamental principle of national treatment. Other provisions include: • the elimination of tariffs by 2010 • national treatment to foreign investment • existing trade restrictions are “grandfathered” or have “sunset” clauses • some goods remain subject to non-tariff trade restrictions (such as Canadian cultural industries)

22. Dispute Settlement Mechanism for NAFTA • There is also an important dispute settlement mechanism: • - a review panel has the power to suspend any antidumping or countervailing duties The results of NAFTA: - Industry has restructured in the direction of greater export orientation in all three countries, and trade creation has occurred.